What is agency in corporate finance?

What is agency in corporate finance?

An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another’s best interests. In corporate finance, an agency problem usually refers to a conflict of interest between a company’s management and the company’s stockholders.

How do debtholders protect themselves?

With managers in control of their money, the chances that there are principal-agent problems for debtholders are quite high. Implementing debt covenants allows lenders to protect themselves from borrowers defaulting on their obligations due to financial actions detrimental to themselves or the business.

Why are executive stock options agency costs?

Agency costs can occur when the interests of the executive management of a corporation conflict with its shareholders. Shareholders may want management to run the company in a certain manner, which increases shareholder value. As a result, the shareholders would experience agency costs.

What is the difference between agency and stewardship theory?

The key difference between agency theory and stewardship theory is that agency theory is an economic model which describes the relationship between principal and agent, whereas stewardship theory is a human model which describes the relationship between principal and steward.

What are the three types of agency costs?

There are three common types of agency costs: monitoring, bonding, and residual loss.

What is Type 2 agency problem?

The conflict between principal and agent can be divided into two types. The agency problem of type 1 refers to the shareholder and management conflicts, which is more common in reality. Type 2 refers to the problems between controlling shareholders and minority shareholders (Shapiro 2005).

What is the underinvestment problem?

Key Takeaways. The underinvestment problem describes a conundrum whereby a company becomes so overleveraged that it can no longer make investments in growth opportunities. Economists recognize this situation as an agency problem that can arise between a firm’s debt holders and equity shareholders.

How might lenders mitigate agency costs?

The most common way of reducing agency costs in a principal-agent relationship is to implement an incentives scheme. There are two types of incentives: financial and non-financial. Financial incentives are the most common incentive schemes.

How can agency costs be avoided?

Do stock options reduce agency costs?

Theoretically, stock option incentives are a way to reduce the agency problem and thereby reduce inefficient investment. Stock option incentives can align the interests between shareholders and managers, thereby reducing the agency problem [1,5–7].